Latest News [index] The taxing question of when is a salary too low?
The recent Supreme Court decision in Penny and Hooper v CIR has confirmed that payment of a below market salary from an associated entity can be tax avoidance.
However, the same decision also recognises that there are many situations where a lower than market salary can be explained by reference to matters other than tax savings. Importantly, this can be the case, even where the lower salary is tax effective, provided that this was not the main reason for setting the salary so low.
Briefly, all the fuss in Penny and Hooper arise because when the top marginal rate increased to 39% Mr Penny and Mr Hooper independently established new trading structures that had the effect of reducing their respective tax bills by between $20,000 and $30,000 per annum.
In the first instance Mr Penny and Mr Hooper argued, correctly, that there was nothing in the Income Tax Act that prevented a taxpayer from being paid a below market salary. Although the High Court accepted this argument, the majority of the Court of Appeal and the entire Supreme Court essentially said, that although the law does not prevent this, if the taxpayer cannot provide any sensible explanation, then the Court can determine that tax saving is the predominant reason. Were such a saving is not one that Parliament contemplated, then it will be tax avoidance under a general overriding provision that targets arrangements that although not strictly contravening any provision of the Income Tax Act, nevertheless amount to tax avoidance.
So far, so unclear.
In the absence of clear rules or legislation what does this mean for salaried taxpayers who are hired by an associated trust or company?
As a general rule where a below market salary is paid for demonstrable reasons (other than tax efficiency), it is unlikley that tax avoidance could be found. This should be the case regardless of whether tax savings acturally result. The sort of situations where this will be the case include:
- payment of a below market salary where there are insufficient funds to pay a market salary;
- payment of a below market salary to enable charitable or other philanthropic activity where the structure through an established structure;
- a long-standing structure where salary levels were set historically and although below market do not represent a departure from a higher salary; and
- accumulating capital for planned expenditure so that there is insufficient funds for more adequate levels of remuneration.
Situations that include elements of artiface or contrivance should be carefully reviewed. For example where a below market salary is paid but the employer makes significant amounts of profit available to the employee by way of loan to the employee or an associate.
If you have any questions about how the decision in Penny and Hooper could apply to you please contact a member of the Ayres Legal team.
Also see http://www.ird.govt.nz/aboutir/media-centre/media-releases/2011/media-release-2011-08-24.html for the IRD's response to the decision.